On 23rd October 2008, former Chairman of the Federal Reserve, Alan Greenspan, returned to Capitol Hill in Washington to appear before the House Committee on Oversight and Government Reform. It had been just one month since the investment bank Lehman Brothers had filed for bankruptcy – a move that had sparked turmoil across financial markets worldwide and which now, five years later, continues to reverberate.
Although he had retired from his position as Chairman a few years earlier, there was no denying that it was Greenspan who was at the wheel when the US economy began to veer towards the subprime precipice – he had held the position for 19 years from 1987 to 2006. The Committee wanted answers. Why had he not spotted the bubble forming in the housing market? Did he now accept that, for his unshakable commitment to free markets and antipathy towards nearly all forms of market regulation, he should shoulder some of the blame for the imploding economy?
“Dr. Greenspan, you were the longest-serving Chairman of the Federal Reserve in history and during this period of time you were perhaps the leading proponent of deregulation of our financial markets. Certainly you were the most influential voice for deregulation. You’ve been a staunch advocate of letting markets regulate themselves,” said California Democrat Henry Waxman and Chair of the Committee. “And my question for you is simple, were you wrong?” “Yes,” replied Greenspan, pausing briefly. “I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”
The ‘maestro’ finds a flaw
It was a startling admission. Had the financial crisis and ensuing recession never occurred, Greenspan would, in all likelihood, have remained one of the most highly regarded central bankers in history. Once lauded as the ‘maestro’, he had guided the US economy through some testing periods – the dot-com boom and bust, for example – leading the economy to one of the most prosperous periods in American history. Now this man, who for decades had been one of the most entrenched, powerful figures in Washington, sat before a Congressional committee conceding that the emerging crisis had forced him to question his most fundamental assumptions about markets.
But what was the flaw he had discovered? Years later, Greenspan would explain that the Fed’s sophisticated forecasting models proved to be faulty because they disregarded those basic elements of human psychology – fear, euphoria and greed – that Keynes once called “animal spirits”. These factors, he says, have always been difficult to quantify and tend to defy algorithms. That, he argues, is why the Fed, the International Monetary Fund (IMF) and many large, highly-sophisticated financial institutions failed to see the coming crisis.
A love of mathematics
Talk of the impact of so-called ‘soft’ issues, such as human psychology, on markets is not something one would normally expect to hear from the mathematical model-worshipping former Chairman of the Fed.
From an early age, Greenspan had been infatuated with numbers. Born in New York in 1926 to a family of east European Jewish ancestry, he showed a precocious talent for mathematics from an early age – so much so that his mother would often have him demonstrate to neighbours his ability to add three digit numbers in his head. While many young children tend to exhibit a strong aversion to learning sums and times tables, Greenspan considered these activities as hobbies. “His idea of relaxation was doing calculus problems,” his wife, TV reporter Andrea Mitchell, once remarked.
In September 1944, at the age of 18, Greenspan’s passion for figures took him to study at New York University where he went on to earn a Master’s degree in Economics and, many years later, a Ph.D. In the 1950s, Greenspan worked as a researcher at the National Industrial Conference Board, before becoming a partner at Wall Street Consulting firm Townsend-Greenspan. In these roles he was able to put this enduring obsession with numbers to practical use.
Despite holding for 19 years what is intended to be an explicitly apolitical role, that of Chairman of the Fed, Greenspan made no secret of his life-long conservative, free-market beliefs. Greenspan has acknowledged on a number of occasions that his conservative ideological convictions were cemented during his association with Ayn Rand, the objectivist philosopher and radical libertarian novelist whose biographer Anne Heller describes as “probably the most important communicator of conservative ideas to the American people”.
Rand and Greenspan met in the 1950s. Greenspan, at the time a self-avowed positivist, took some convincing before coming around to Rand’s objectivist philosophy, eventually becoming one of her most loyal acolytes. He came to accept – although not in its entirety – Rand’s libertarian ideology, which held individualism to be the highest ideal and advocated unfettered free market competition with little role for the state – save the preservation of law and order.
In the early 1970s Greenspan, determined to use his aptitude for economics to further the cause of conservatism in America, became involved in the Republican Party in an advisory capacity. He began by working as an advisor for the then presidential candidate, Richard Nixon, pressing on him his ideas for reducing government expenditure and restraining the budget. He quickly earned a reputation within Nixon’s inner circle and the wider Republican Party as a man who could advise on a range of issues – energy, agriculture and welfare policy – far beyond the borders of his usual domain, economics.
“In terms of raw influence he was a resource matched by almost no other,” Dick Allen, Nixon’s Foreign Policy Communicator, later recalled. “The guy has a concept of how the world should be organised and he pursues it relentlessly.”
Greenspan’s reputation within the Republican Party continued to grow and, in 1974, he accepted his first role in government, becoming a member of the President’s Council of Economic Advisors. Fittingly, Greenspan invited his mentor Rand to stand at his side for the ceremony in which President Gerald Ford swore him in to the role.
After Gerald Ford was defeated by the Democrat Jimmy Carter in the 1976 US presidential elections, Greenspan took a long sabbatical from governmental service and did not return to Capitol Hill in any official capacity until President Ronald Reagan nominated him to replace Paul Volker as the Chairman of the Board of Governors of the Federal Reserve.
Although Greenspan was chosen, in part, because of his conservative background, the Republican’s soon found out that conservative beliefs didn’t necessarily equate to loyalty to the Republican Party. As a conservative economist, his ultimate allegiance was to a balanced budget – and the political party who delivered that was, to him, almost an irrelevance. It was for this reason that he eventually came to hold Bill Clinton in much higher esteem than either Reagan or George Bush Senior. Clinton, after all, ended his two terms as President with a sizable budget surplus, while in the course of Reagan’s eight years in office, the national debt tripled, growing from $930 billion to $2.6 trillion.
In his role as Chairman of the Fed Greenspan came to amass considerable political power, using his influence over financial markets as leverage to help him to achieve political objectives. For example, following Clinton’s election victory in 1992, he arranged a meeting with the president-elect. On the campaign trail, Clinton had indicated he would introduce a progressive tax to fund a programme of ambitious social policies – something which Greenspan naturally opposed. In the end, Clinton was persuaded to introduce a tax not targeted at the rich when Greenspan offered, in return, a cut in interest rates to boost the economy and his support for the budget deal opposed by congressional Republican’s.
The “Greenspan put”
During his stint as Chairman of the Fed, Greenspan also developed his own, distinctive approach to monetary policy. Whenever the US economy was in trouble, Greenspan believed he could recharge it by cutting rates sharply. It became to be known as the ‘Greenspan put’ – and he exercised this policy approach on a number of occasions, beginning with the ‘Black Monday’ stock market crash in 1987. On Monday 19th October 1987, stock markets around the world crashed. Greenspan, who had begun his tenure at the Fed only months before, lowered the Federal Funds rate in order to pump liquidity into the markets. The policy was a success, allowing investors to borrow funds more cheaply to invest in the securities market and, thereby, stimulating a strong rally that won back a portion of the earlier losses.
However, as Greenspan himself later came to admit, short-term successes can sometimes have long-term repercussions for central bankers. In 2002, Greenspan resorted to the same tactic in an attempt to kick-start the US economy following the 11th September terrorist attacks on the World Trade Centre. The target Federal Funds rate was cut again, this time to 1%. It was the lowest the rate had been since the 1950s and it would remain at that level until mid-2004. As before, the policy achieved its objective. The stock markets recovered and the US economy was soon booming again.
However, low interest rates became the source of the housing market bubble. With interest frequently negative in inflation-adjusted terms, investors and lenders were pushed to take bigger risks to get better returns. In this search for yield, financial intermediaries extended credit to homebuyers with limited financial means and often poor credit records. These homebuyers, in turn, were easily seduced into taking out adjustable rate mortgages (ARMs) by the combination of a low interest rate environment and, at least on the face of it, perpetually rising house prices.
Never saw it coming
The rest, as they say, is history. Greenspan raised rates back up in 2004 and, two years later, billions of dollars of ARMs began to be reset at upwards. As house prices began to plummet and mortgage defaults rose, the enormously leveraged banks and brokers of Wall Street incurred huge losses as a result of all the subprime assets on their balance sheets. By 2008, the resulting contagion had spread across the globe and caused the collapse of some of the world’s largest financial institutions and the bailout of banks by national governments.
Naturally, Greenspan’s actions – and inactions – during his tenure as Chairman of the Fed came under intense scrutiny in the wake of the crisis. That his approach to monetary policy played some role in the forming of the US housing bubble is now widely acknowledged, including by Greenspan himself. However, as the Financial Times columnist Martin Wolf wrote in Greenspan’s defence back in 2008, the housing bubble was not unique to the US. On the contrary, during this period housing bubbles formed in more than two dozen countries around the world, a phenomena that appears to demand an explanation that is global and not focused entirely on the decisions taken by one individual.
Another argument is that the subprime asset bubble could have been prevented if Greenspan had adopted a tougher regulatory stance on derivatives and shadow banking. Furthermore, with all of the Fed’s sophisticated forecasting technology at his fingertips, he should have spotted the bubble forming and done something to prevent it from growing. On these points, it is difficult to absolve the former Chairman.
Greenspan, like many of his peers in the US government, subscribed to the efficient-market hypothesis. Essentially, this is the belief that the financial sector would always act in rational self-interest and, therefore, the technologically advanced financial markets of what he called the ‘new economy’ were best left to police themselves.
In his recent book and mea culpa, ‘The Map and the Territory: Risk, Human Nature and the Future of Forecasting’, he concedes that this rationale had proved to be deeply flawed. While markets often do behave in rational ways which forecasting models can easily predict, they can also become irrational when driven by ‘animal spirits’.
But Greenspan is adamant that this doesn’t necessarily mean such models should now be dispensed with. In his book, he explains that it is possible to measure and factor in such things as ‘fear’ and ‘euphoria’ into models alongside traditional variables such as interest rates and corporate earnings. “September 2008 was a watershed moment for forecasters, myself included,” he writes. “It has forced us to incorporate into our macro models those animal spirits that dominate finance.”
Greenspan in quotes
“Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”
Speaking to a Senate Committee in 1987, as quoted in the Guardian Weekly, November 4, 2005
“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
February 2004 speech on the benefits of adjustable-rate mortgages
“Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.”
November 2004 speech in Frankfurt
“Everybody is hurt by inflation. If you really wanted to examine who percentage-wise is hurt the most in their incomes, it is the Wall Street brokers. I mean their incomes have gone down the most.”
At a conference on inflation in Washington D.C., September 1974
We generally did not talk about the stock market very much at the Fed.
Chapter Eight, ‘Irrational Exuberance’, p. 165
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